Credit Risk -

Risk Management
Techniques
Lecture Week 11

BANK3011 BANK FINANCIAL MANAGEMENT

PAUL MARTIN
Objectives of this Week
– To Recap the significance of diversification in portfolios of
credit sensitive assets
– A practical demonstration from an example Creditmetrics style model
– To examine how credit risk can be managed using:
– Traditional Credit Management Techniques
– As Background to examine the traditional market for the sale of loans as
background, examining how it operates in the US and the motivations
– Advanced Credit Management Techniques
• Asset Securitisation
– Structures, including CDO’s
– Significance for bank management
• An introduction to Credit Derivatives
– What are CD’s
– Use of CD’s in credit management
– References
– Securitisation Lange Chapter 8
– Credit Derivatives – Lange Chapter 11
Recap from Week 10
– The Usefulness of Credit Models
– Provide an overall view of the portfolio
– Assessing the extent of portfolio concentrations
– Provided correlations are well understood VaR can
provide an aggregate value for the portfolio’s risk
– Allow an analysis of the incremental impact of adding
credit assets to a portfolio
– Portfolio simulation
– Allow the risk resulting from the potential failure of
numerous obligors occurring simultaneously to be
assessed
– Incorporates the effects of correlations between credit assets
A Sample CreditMetrics Model
Managing Credit Risk
– Credit risk measurement is required at both the individual
loan level as well as at the portfolio level
– At the individual loan level the bank will monitor the creditworthiness of
individual loans, generally for large loans only.
• This enables banks to decide if any pre-emptive action is required, for
example increase collateral or in extreme case seek repayment if terms
allow.
– At the portfolio level the bank will monitor the concentration risk within
the portfolio.
– This is one of the key economic functions we noted in Week 1that banks
perform.
– To a large extent however the ability of banks to
manage credit risk has been limited
– Traditional way is transfer loans to someone else
– The loan sales market has been significant in the US
Loan Sales
Types of Loan Sales Contracts
– Historically this is the simplest way to transfer the risk
– Participations
– Loan Syndications are an important example of participations
• A participation in a syndicated loan is often transferrable
– There is however limited contractual control in these structures
– Assignments (the US Loan Sales Market)
– The bulk of the US market (90% +)
– All rights transferred on sale of loan
– Loan sales suffer from a number of key limitations including:
– Loans are essentially not readily marketable or saleable assets
– The customer relationship may be adversely impacted
– Transaction costs are likely to be high, market liquidity is often low
– Complexity e.g. the treatment of accrued interest, not standardized as it is for
bonds.
– The risk of fraud, particularly because loans are not held in a registry like
tradeable bonds.
Participants in the US Loan Sales Market
– Buyers
– Inter-bank loan sales in traditional market historically due to
US branching restrictions.
– Buyers of distressed loans generally investment banks*,
hedge funds or vulture funds.
– Foreign banks* dominant buyer of domestic USD loans
– Insurance companies* and pension funds seeking long-term
investments.
– Mutual or managed funds and non-financial firms
– Sellers
– Major money center banks*, U.S. government and its agencies*
(Freddie Mac etc.).
* Hence the involvement of these organisations in GFC in
which housing loans (including sub-prime housing loans) were
traded.
Advanced Credit Risk
Management Techniques

Asset Securitisation
Credit Derivatives
Advanced Methods to Manage Credit Risk

Asset Securitisation
Credit Derivatives
– Both represent different techniques for removing all or part
of credit exposures from a bank’s balance sheet
– Thus enabling credit risk to be managed by altering the
portfolio’s concentration or the extent of diversification
– This is our focus on the use of these transactions
– Both represent advances over traditional loan sales because
they create marketable instruments
– Either cash or derivative instruments
– They can also be used to add specific types of credit risk to
a portfolio thus enhancing portfolio diversification where no
risk to that asset or asset class is currently held in the
portfolio.
Other Motives and Consequences of a Bank
Undertaking Loan Securitisation
– Duration management
– The duration gap is affected since assets (and their duration) are removed
from the balance sheet of the bank sponsoring the securitisation (Lange
Ch. 8)
– Liquidity management
– Liquidity is affected because cash is received by the bank initiating the
Securitisation, this will be considered in Week 12
– Capital management
– Capital requirements are reduced, e.g. Basel 2 and Basel 3, this will be
considered in Week 13.
– Funding
– The bank replaces the funding and the related funding cost via the
Securitisation
– Generates Fee Income for the FI
– Fees are received for the ongoing management of the Securitisation
– Any profits from the sale are recorded as trading income
Three Broad Types of Cashflow Securitisation
– Pass-Through Securities (Ginnie Mae, Freddie Mac) pp278-284
– Mortgage Backed Bonds (pp294-295)
– Collateralised Debt/Mortgage Obligation (pp289-294) as follows:

Payment for Assets Payment for Bonds

Originator (Bank)

Class A bonds

Bondholder
Investor or
Transfer of Assets Class B bonds
SPV
etc.

Loans Collateral

SPV= Special
Purpose Vehicle Credit Enhancement Source: APRA
 The Special Purpose Vehicle (SPV)
– The SPV is established by the originating bank.
– The role of the SPV is to manage the assets (loans and securities)
owned by the SPV and is the issuer of the CDO securities to the
investors
– The SPV is usually a trust, which means that whilst it legally owns
the assets, it holds them for the benefit of the investor or
bondholder (the investor is the beneficial owner)
– The SPV must be separate from the bank. The bank may act as
manager of the SPV (if so earning a fee for performing such
services) but cannot own or control the SPV. This means that the
SPV’s assets no longer belong to or are controlled by the Bank.
– Thus the bank does not need to consolidate this entity for accounting
purposes and the assets are no longer assets of the bank – THEY HAVE BEEN
SOLD
CMO or CDO - Bond Classes

– The Bond Classes in a CMO can be established on the

basis of:
– Repayment risk
• e.g. Class A are repaid first when any underlying loans are repaid
early, Class B are not repaid until all Class A bonds are and so on

– Default risk
• e.g. Class C bonds incur any credit losses first, then in turn the other
classes once class C has been exhausted (Class C is subordinated and
is in effect quasi-equity)
• This is the basis of establishing bond classes of interest to us

– A combination of both
 Asset Securitisation - Credit Enhancement

The Credit quality of the securitised assets can be enhanced through

one or a combination of the following:
– Mortgage insurance
• Generally applies where the Loan to Value Ratio (LVR) exceeds 80%
• Two principle providers in Australia – Genworth and QBE
– Guarantees or Letters of Credit
• Issued by the originating financial institution or another FI e.g. insurance
company
– Credit derivatives (see the following slides)
• Note also their role in the GFC
• Credit derivatives in essence provide a guarantee because the protection
seller is obligated to compensate the buyer for any losses
Typical Credit Derivatives

– Total Rate of Return Swaps

– Credit Default Swaps
– Other types of credit derivatives
– Basket Swaps
• Where the underlying credit/s is a group of obligors
– Credit Linked Notes
• Where the derivative is used to overlay another asset to create a
synthetic security
– Credit Spread Options
• Where the buyer obtains protection if the credit spread changes from
its current level.
The Australian Credit Derivative Market Turnover (AUD)

Transaction 2004-05 2008-09 2009-10 2011-12 2012-13 2013-14 2014-15

Credit 45,330 185,685 108,610 121,031 48,153 65,136 67,570

Default
Swaps
Total Rate of 0 143 320 228 389 0 -
Return
Swaps
Basket 1,867 146,223 137,873 289,669 180,066 164,551 57,863
Swaps and
Credit
Indices
Total 46,179 332,051 246,803 410,927 228,608 229,687 125,433

Source: AFMA data collection ceased in 2015

Total Rate of Return Swap (TROR)

– An agreement in which the total return of an underlying

credit sensitive asset or pool of assets is exchanged for some
other cashflow
– No principal is exchanged & no change in physical
ownership occurs
– Contract specifies notional amount and the dates on which
payments will be made
TROR Swap in Practice

– Protection seller pays Interest + spread + losses on

the credit risky bond/loan
– Protection buyer pays Total Return on the credit
risky bond/loan

Protection Protection
Seller Buyer

Credit
Risky
Bond/Loan
Effects of a TROR Swap

– The protection buyer effectively goes short of the asset

(sells it)
– The protection seller effectively goes long of the asset
(buys it)
– The seller assumes the economic risks of the credit risky
asset, but not the asset itself, i.e. the asset is not acquired
– Cashflows can be interest, coupons or dividends or even
capital
Attributes of a TROR Swap

– The maturity need not match that of the underlying

– Can include caps and/or floors on the rate
– Like interest rate swaps they can be used to exploit an
arbitrage
Credit Default Swap

– An agreement in which a periodic or upfront payment is

made by the buyer in return for the promise to pay
unspecified payments from the protection if a predetermined
credit event occurs

– No principal is exchanged & no change in physical

ownership occurs
– Contract specifies notional amount and the credit events
which will trigger payments
Credit Default Swap in Practice

– Protection seller pays an unspecified amount (credit event

payment - CEP) if a specified credit event occurs
– Protection buyer pays agreed basis points x notional
principal (the swap spread)

CEP
Credit Event
Protection Zero
Protection

Seller Buyer
No Credit Event (Swap Spread)
Bought by Buyer

Credit
Risky
Bond/Loan
Credit Default Swap Characteristics

– The protection buyer effectively goes short of credit

– The protection seller effectively goes long of credit
– There is no exchange of principal & therefore no funding
cost, so the seller assumes the credit without funding the
loan
– The buyer retains the loan (and relationship) but effectively
removes credit exposures (usually default risk)
 Attributes of Credit Default Swaps

– Ideally suited to be able to manage portfolio concentration

risk
– Credit default swaps can be on a “basket” of cashflows
(issuer names)
– Terms are generally for one year and longer
– Credit risk is effectively transferred between the parties
The Use of Credit Derivatives
– Trading Instrument
– The underlying loans (bonds) can be bought or sold
synthetically, but there is no funding required
– The risk and return is the same as the underlying bond.
– Hedging Instrument
– Management of risk in particular transactions
– Allows portfolio concentrations to be reduced by “selling the
loan” i.e. buying protection
– Allows portfolio diversification by “buying a loan” i.e. selling
protection
– Risk Transfer Instrument
– The management of portfolio risk by transferring risks to the
counterparty in the CDS
Using CDS’ for Credit Risk Management
– Buying protection reduces portfolio concentration or
individual loan exposure
– By effectively removing the asset’s credit risk from the portfolio
– Sell protection to diversify risk
– By effectively adding the asset’s credit risk to the portfolio
– No funding required
– Fixed Income investors can enhance yield
– The CDS can be embedded into a fixed interest security e.g. a
standard bond to enhance yield
– e.g. Credit Linked Notes
– Protect against future changes to credit spreads
– Through the use of credit spread CDS’

Note CD’s create counterparty exposure

 Summary of Managing Credit Exposure
– Traditionally loan exposure is reduced by selling the loan/bond or
– Buying a loan to obligors to whom we have no current or little exposure.

– Modern/Alternative Risk Reduction Strategies

– Originating a CDO is a more effective way of selling loans
– Alternatively CDS’ can be used to reduce exposure to an obligor or group of
obligors by buying protection using either TROR Swaps or a Credit Default Swaps
• These transactions reduce the portfolio’s concentration to the assets underlying
the CDO or the credit derivative.

– Modern/Alternative Risk Diversification Strategies

– Selling protection using:
• TROR swap or a Credit Default Swap
• Basket swaps (bundles of credits)
– Alternatively buying a CDO
• These transactions may also result in credit risk diversification by creating
an investment/loan in an asset or class of asset in which we have no or little
current exposure,
• As such it assists in diversifying the portfolio of loans or other credit
sensitive assets